11th September 2014
Toby Nangle, head of multi-asset allocation at fund manager Threadneedle Investments, looks at the implications of a ‘Yes’ vote for Scottish independence on the country’s currency, economy and its people…
The market’s scepticism that Scotland will vote for independence on 18th September has been meaningfully tested by recent opinion polls, which have shown the sizeable majority in the ‘No’ camp evaporate into statistical insignificance. As such, the outcome looks too close to call. And the financial market implications of a vote for an Independent Scotland appear meaningful.
Currency union break-ups have been rare and tumultuous events, hence we expect international interest to be significant. In Scotland’s case, scrutiny over the course of a break-up in the event of independence would be intense: the country is highly developed and has an outsized financial sector relative to the rest of its economy.
Even if the ‘Yes’ vote fails to win the day, a close vote could mean companies could start organising their affairs on the basis that separation remains possible, leading to lower investment in Scotland.
What could a new currency look like?
Starting with the basics, the choice of currency regime post potential independence is far from clear. But the advice commissioned by HM Treasury, and extraordinary intervention of Sir Nicholas McPherson – permanent secretary to HM Treasury – is unequivocally against a monetary union. This makes the unanimous rejection by UK political parties of a monetary union with an independent Scotland appear more than grandstanding, and leaves two currency options:
1) Sterlingisation, eg unilateral adoption of the pound but with no say in monetary affairs or access to the central bank as lender of last resort, or
2) a new independent currency.
The investment implications of the two different choices vary, but neither looks likely to be conducive to short-term financial stability. It seems reasonable to question whether Scottish depositors might be tempted to doubt the degree to which an independent Scotland will be able to maintain a currency peg or whether a new Scottish currency would suit their needs, and seek to shift their deposits to the UK. This would put immense pressure on both the peg and the remaining financial system, potentially leading to a Scottish government bankruptcy. It happened in Argentina in 2001, when it was forced off the US dollar by failing depositor and investor confidence.
Implications for Scottish banks
The balance sheet of Scottish banks is around twelve times the size of Scottish GDP (versus around five times for the rest of the UK), bringing financial system stability into focus. Scottish banks would retain the ability to access the Bank of England as a Lender of Last Resort before independence was completed in 2016. Assuming banks will need to continue to have this access, we would expect the bulk of the banking system to shift domicile south of the border before 2016 (they would be required to do so under EU law and the Bank of England regulatory requirements, given that this is where the majority of its business lies). This would leave banks in Scotland run either as foreign branches or separately capitalised Scottish subsidiaries.
Uncertainties could impact risk assets
Markets dislike uncertainty and the timetable for complex negotiations surrounding constitutional divorce is necessarily long. Given the constitutional and economic uncertainties attached to a potential break-up of the UK, a vote for independence would likely deliver a negative shock to UK financial assets and lead to meaningful currency weakness. However, despite the change in polling, financial markets still attach a very low probability to independence. We are unable to discern any meaningful risk premium in UK equities, and the sterling weakness experienced over the past month has been principally against the US dollar: against the Euro and the Yen Sterling is almost unchanged.
A brand new currency would be unlikely to deter international investors from financing good projects on the ground with solid fundamentals. But, absent a crash in asset prices exposing immediate cheap valuations, investors would likely want to wait until the fog of political, monetary, financial and economic uncertainties that would envelop an independent Scotland lifted before committing funds.
In addition, Scottish and other UK companies that historically operated defined benefit pension schemes with a large workforce split between Scotland and the rest of the United Kingdom may, in the event that an independent Scotland joined the EU, find that they had new ‘Section 75 Debt’ liabilities owing to the cross-border nature of their pension fund membership. While this sounds pretty arcane, it would likely be extremely costly for many firms. Understanding where these costs lie and how large they would be could impact these companies’ stocks and bonds meaningfully, although there is a chance that legislative changes could be negotiated at the European level to avoid this large an mostly unknown cost arising.
Other investment implications
Scottish banks could see their value fall should they suffer depositor flight. Domestic Scottish-facing companies with significant amounts of Sterling debt referencing English Law may find their assets and liabilities no longer matched (eg they would have sterling liabilities but Scottish currency revenues). This situation has caused all sorts of problems in emerging markets where this sort of mismatch is most common.
Scottish energy companies could be advantaged by a change in taxation arrangements that moved their incentives more in line with those seen in Norway, although there would be large question marks over North Sea oil decommissioning costs that the UK government has historically been seen to be backstopping.
Given the likely hit to business confidence that would come from the political and constitutional uncertainty following a ‘Yes’ vote, we would expect the Bank of England to delay or slow its hiking path. As such, short-dated gilts would perform strongly. Long-dated gilts may benefit from a ‘flight to quality’ although international reserve managers perspectives on the political developments introduces uncertainties into this call.
Even if the ‘Yes’ vote fails to win the day and the ‘No’ vote triumphs by a slim majority, the prospect of a ‘Neverendum’ remains. And while less disruptive to financial markets, this looks to be of great danger to the people of Scotland. It is likely that companies will organise their affairs from now on, on the basis that separation is possible if not likely, and this is likely to lead to lower levels of investment in Scotland that would otherwise have been the case – as has been documented in the case of Quebec following their referenda to leave Canada.